Stealth-Bailout: Why Sinn is Only Partially Right, But Things Might Be Even Worse

There was a lot of discussion, notably by Olaf Storbeck, on Hans Werner Sinn’s claim that the European Central Bank (ECB) performed a „stealth bailout“ on the GIPS countries via its TARGET-2 system. To my understanding, he’s partly right. Maybe there is a stealth bailout, but it is to my understanding unrelated to TARGET-2. Read here why.
In his latest piece, Sinn made the following points that I repeat in my own words because his article was in German and they were also not always stated clear enough to extract them as a short quote.

Sinn’s point #1: TARGET-2 Accounts Act Like Short-term Eurobonds

Sinn claims that the TARGET-2 system is economically equivalent to a short-term Eurobond. Issuer of these „bonds“ is the European Central Bank System (ECBS), the system of the European national central banks and the European Central Bank (ECB) itself. As with the „normal“ (yet unexisting) Eurobonds, all member countries guarantee the payback of the bonds according to their share in the ECBS. In case of the ECBS this is done via the national central banks.

Alleged buyer of the TARGET-2-Eurobonds is the national bank that the money is transferred to. It holds a claim towards the ECBS. Sinn refers here to an example of an Irish farmer buying a German tractor and transferring the money via the Allied Irish Bank (AIB), the Central Bank of Irland (CBI), and the Bundesbank to Germany’s Deutsche Bank. In this example, the buyer of the TARGET-2-Eurobonds is Germany’s Bundesbank. In case of a break-down of the ECBS, the Bundesbank holds a debt claim to member national banks (including itself) according to their respective share in the ECBS. Sinn is right that, until this point, the TARGET-2 is acting like a short-term Eurobond.

The proceeds of the bond are used by CBI to refinance AIB’s credit to Sinn’s farmer. CBI receives collateral from AIB. Indeed it will apply haircuts to the collateral posted, so it will demand more collateral than just the credit of the farmer. This point is not recognized enough from Sinn in my opinion. But it is central: Target2-Accounts act like short-term Covered Eurobonds. This sounds like a small technical detail, but makes it actually a totally different story.

In case of default, a bank’s loss on an uncollateralized loan easily reach levels of 90% the loan’s nominal value. For the collateralized loans, such as good managed covered bonds, that is unlikely to be more than 10%. The credit risk is smaller by a factor of nine.

Sinn’s point #2: Target-2 is a forced Capital Export from Germany to the GIPS

Sinn’s argument: „As Germany can’t object transferring the money via Target-2 and thus can’t object buying the Target2-Eurobond“. I have some doubts on that claim. It is certainly true, that Germany can’t object, but it only amounts to capital transfer if the price, i.e. the interest rate paid, is too low and off-market. Otherwise it is just a cash-transfer and a liquidity conversion. As the Target-2 exposures are collateralized and short-term, the fair interest rate should be equal to the money market rates and thus in the current environment very low. So the used interest rate is unlikely off-market enough to make it a scandal, but it is apparently off-market enough to make it attractive and cause the large TARGET-2 account deficits of the GIPS and surpluses of Germany. If, however, the exposure is not collateralized effectively, the interest rate might be far too low.

Sinn’s point #3: The Collateral Accepted By The ECBS is Of Low Quality

Without stating this explicitly, Sinn argues that the Target-2-Bond is actually under-collateralized because the ECB reduced the minimum rating requirements for bonds to be accepted as collateral. I tend to agree and I actually think this was a key mistake of the ECB. But this is not limited to Target-2 but also affects issued money that never left a member country likewise.

So even if the Irish farmer buys a tractor from an Irish producer, again financed by AIB, the collateral posted by AIB to the CIB might actually be insufficient to cover the credit risk. There is no Target-2 involved, no money transfer to Germany, but still the Bundesbank will guarantee the credit risk involved. That is, the whole European Central Banking System is actually a short-term covered Eurobond – regardless if transactions are settled via Target-2 or not.

Let me say a few words on why I think the ECBS has a problem with the collateral it accepts. On the first glance, accepting low rated bonds shouldn’t be such a big issue as collaterialization works on market values with daily margining. That is, if a Greek bond has such a high credit risk that it is worth only 50cent the Euro, the ECBS will also only treat it as 50cent collateral and even will apply a haircut to it. (Note: there are quite a few stories in the blogs claiming it would handout 1 Euro in cash on 50cent Greek bonds. This is not true as you can see in the ECBS constitutional document, page 49: „The haircuts are applied by deducting a certain percentage from the market value of the underlying asset.“)

However, if you look at the details, things are not that clear anymore and I fail to make up a definite opinion on that. Let me begin with what I’m sure about: The return distribution of credit risk is highly skewed. In non-mathematical terms that means: If you are exposed to credit risk, you are very likely to win a small amount of money, but in case you lose money that is going to be a big amount. So if the ECBS now accepts low rated bonds as collateral, it increases the chance of suffering a big loss. This is further amplified by the fact that the value of the collateral is highly correlated with the ability of the borrower to service his debt. In other words, if Greece defaults both all Greek banks will be insolvent and at the same time the collateral will lose much of its value. Generally speaking, the ECBS shouldn’t accept bonds issued by European banks or member countries at all. Actually, accepting collateral that has a high correlation to the default risk of the borrower is such bad practice that it is usually outright forbidden for banks. For example the Basel-2 Accord demands in Article 124:

In order for collateral to provide protection, the credit quality of the counterparty and the value of the collateral must not have a material positive correlation. For example, securities issued by the counterparty ─ or by any related group entity ─ would provide little protection and so would be ineligible.

For an Irish bank posting Irish government bonds as collateral this is arguably not independent as it was the government that bailout the banks in the first place and its guarantee still keeps the banking system alive. As the default risk of the bank and Ireland itself are not independent, this is equal to an uncollateralized credit to Ireland itself and thus we have a stealth-bailout here. But this is totally independent from TARGET-2.

Is the stealth bailout a significant amount? I don’t know. It depends on the share of collateral of questionable quality that he ECBS accepted. Might be significant. Might be very insignificant.

Summary

Sinn is wrong. TARGET-2 is not amounting to a stealth bailout.

Sinn is right. The ECBS in fact is a short-term Eurobond in disguise. However, Sinn seems to neglect the fact that this is a Covered Eurobond.

Sinn is maybe wrong. TARGET-2 does not necessarily show there is a massive forced capital transfer from Germany to the GIPS. This would only be the case if the interest rates for TARGET-2 would be way off-market. However, they may be somewhat off-market as apparently using TARGET-2 is very attractive at the moment. Given the low short-term interest rates it is unlikely to be very off-market, but then if it turns out to be less collateralized than intended it may well be.

Sinn is maybe right. Sinn doubts that the collateral accepted by the ECBS is all that valuable. It is difficult for an outsider to judge this, but given the high correlation between government bonds and the banks‘ credit risk, he might be right. If so, then the exposures of the ECBS are having the same risk content of uncollateralized government bonds and we’d have indeed a „stealth bailout“ of the GIPS and it will be difficult to contain inflation if the system doesn’t change.

UPDATE:
The Economist argues that even in a case of a 50% haircut on Greek debt, the ECBS should be still covered. If so, than we do not have a problem. I have some doubts though. It also notes that the loss on outright purchases of Greek bonds would be 18 billion.